Pain remains for UK banks

June 2014 | FEATURE | BANKING & FINANCE

Financier Worldwide Magazine

June 2014 Issue

After years of scandal the outlook for the UK’s banking sector is slowly beginning to improve. In 2013 the five largest UK headquartered banks – Barclays, Royal Bank of Scotland (RBS), Lloyds, HSBC and Standard Chartered – all announced they had returned to profitability. Although RBS did announce its largest loss since the onset of the financial crisis, the bank was finally profitable at the operating level before impairment losses. Indeed, in 2013, underlying core profits at all five banks increased, loan impairments were trending down and there were nascent improvements in lending volumes.

Despite these notable improvements, the UK’s banking system is not yet out of danger. Consumer confidence in the sector is still extremely low. Furthermore, many British banks, including the five heavyweights, are still being forced to look for operational synergies wherever possible. To that end, a number of banks have announced significant job cuts in 2014. In February Barclays announced it intends to eliminate as many as 12,000 jobs after its fourth quarter 2013 profit fell heavily. In addition to recent job cuts, RBS has already announced the reduction of its investment bank operations. The company is still attempting to revive its earnings after incurring losses of £46bn following its government bailout in 2008. The recent cuts, as well as those yet to come, were precipitated by poor average returns on equity (RoE). RoEs in the UK continue to trade in single digits, lower than the banks’ cost of capital. It is these low RoEs that have led to compressed margins and further cost cutting measures.

A new KPMG report – Reinvention of UK banking, UK banks: performance benchmarking report – notes that the UK’s major banks still face a number of challenges across many fronts. Since the onset of the financial crisis the UK banking system has become markedly more risk averse. This is in stark contrast to laissez-faire attitudes seen prior to 2008. In the wake of the financial crisis UK banks have endured approximately £28.5bn of costs for litigation, fines and customer compensation. A further £19bn has also been earmarked for compensation for clients wrongly sold payment-protection insurance (PPI). In total, in 2013 fines and penalties for mis-selling wiped out 80 percent of the UK’s top banks’ profits. The bill for litigation and fines in 2013 amounted to around £10.5bn.

RoEs in the UK continue to trade in single digits.

Furthermore, in the last five years, the total assets of British lenders have declined by around 25 percent to approximately £5.2 trillion. The reduction of the banks’ balance sheets has been carried out in order to satisfy regulators and avoid a repeat of the reckless behaviour that helped trigger the financial crisis. Since the 2008 credit crisis, global regulators have pushed financial services firms to hold more capital relative to what they borrow to make investments. According to the KPMG report, the industry’s shrinking UK asset base is a result of banks’ reduced derivatives exposure, lending and trading strategies, and lower appetite for risk. “Some of the dark clouds which loomed over the UK banks in the first half of the year remain and have become darker,” KPMG said. “Banks continue to need more capital, margins continue to compress, returns on equity are still much lower than pre-crisis years and most importantly, costs, fines and penalties for customer redress and misconduct issues continue to dominate the agenda.”

In light of these and other challenges, KPMG calls for wholesale reform of the UK banking sector. Richard McCarthy, the firm’s UK head of banking, believes that “To be viable businesses and support economic growth, banks need to make sensible returns for investors but they must do so at the same time as delivering value to customers. This equilibrium is proving an ongoing challenge to achieve, especially with all of the new regulation and additional capital and risk management costs.” He adds, “At the moment, small steps are being taken and we are slowly inching closer to getting this right. But what the banks really need is a total metamorphosis in their business models.”

KPMG believes that the UK banking system must be reformed in order to provide returns to shareholders and products to customers. The regulatory obligations now placed on banks will also require a general overhaul of business models. As a result, banks should prioritise those customers and locations that they can adequately serve, and provide acceptable returns. They must also develop products which can meet the rapidly changing needs of customers, while also accepting and embracing technological change. By adapting to new operating platforms and data analytical tools, banks can improve the way in which they operate, strengthening crucial risk management operations and addressing growing cyber risks.